Beware of 'addiction' to thumping returns on equity in the banking industry

Top Indonesia’s banks continue to get stiff valuation after posting strong profits in H1 2011. To illustrate its exceptionality, I gathered price to book ratios (PBV) and returns on equity (ROE) of three largest Indonesian banks (total market share > 35%) and largest banks from emerging G20 countries experiencing strong economic growth: Brazil, India and Turkey. I also added data from three largest Malaysian banks (Malaysia being Indonesia’s peer despite having much larger financial sector) and data from several world’s largest banks.

The ratios are widely used in analysis because the book value of equity in a bank is given more weight than in other sectors due to market-to-market and regulatory capital rules. Book value as the denominator in PBV is also much less affected by the economic cycle than earnings as the denominator in price/earnings ratio.

The upper graph below clearly shows that the three largest Indonesian banks' PBVs are much higher than banks in some of today’s hottest banking sectors.

PBV of “1” means that you can buy banks close to its liquidation value, which is not bad. Historically, top banks were considered cheap when they were priced around book value, and expensive when they trade for two times of the book value and higher.
With PBV lower than 1 (except JP Morgan), world’s largest banks are still being penalized either for credit quality trouble or low returns. Some investors out there might also hold skepticism over their business model, or accounting used to arrive at book value.

The Indonesian bank stocks in this comparison hence look very expensive indeed and probably not priced for any disappointment like inflation or problem loans being much higher than expected.

The lower graph shows high ROE of Brazil's and Indonesia's top banks with Bank Rakyat Indonesia (BRI, the second largest Indonesian bank) handing down a walloping return on equity of nearly 39%. Note that high returns have been around for sometime in these countries (not shown in this occassion).

To put the exceptional profitability of Indonesia’s largest banks in an economic cycle context, consider the following excerpt showing shareholder returns of largest banks in the euro area. Average return on equity of largest banks in euro area was ‘only’ about 15% during the credit boom years.

                            Notes: * Based on available figures for 20 IFRS-reporting large and complex banking groups in the euro area
                                            * See European Central Bank, Financial stability Review, June 2011, table S5.

Profitability under upcoming regulations 
The central bank (BI) has recently introduced a Prime Lending Rate disclosure requirement. This is a welcome initiative (though not yet a game changer) that would improve transparency and market competition.

As is well-known, high NIM has been a key driver of Indonesian banking sector's profitability. Despite a relatively competitive market structure (btw, not necessarily competitive behaviour), the NIM of large banks, in particular, has stayed high thanks to low-cost current and savings accounts, or CASA, which make up a large portion of banks' core funding. 

Unlike (big) debtors and depositors, savers have a limited price awareness and likely put up with low saving yields. While lending rates might fall thanks to improved disclosures, compensation to saving public remains low, or might be pressed further down as banks attempt to retain their high NIM. Lack of saving rates transparency and obstacles to switching accounts do not help to raise responsiveness to saving returns.

Enhanced consumer education and protection can counter some of the forces behind the high returns on equity obtained at the expense of other stakeholders, i.e. savers/depositors.
Future regulatory landscape would also erode the advantage of CASA. For example, under the new liquidity standards of Basel 3 - CASA will receive less favorable weight as compared to time deposits. This means that cost of fundings is going to rise provided a proper implementation of the Basel 3 standards.

What goes up must come down
The supercharged profits and valuation in Indonesia are partially for the right reasons. Growth data looks healthy and inflation has dropped for six months. On the other hand, the stellar performance in the financial industry has been enabled by short-term capital inflows, commodities export boom and also, loose regulations permitting banks to take on more asset and liquidity risks. The issue being flagged here is the danger of taking unnecessary risks due to an 'addiction' to unusual returns on equity.

Business conditions can be less benign or hit by unexpected event as such that without a closer supervision, bank managers may choose to load up on riskier, high-profit margin loans to dodge downward pressures on the return on equity. Other scenarios are possible as well. When lending rates decline due to lower risk premium and optimism, lenders might also increase risk taking in 'search for yield', which can cause trouble if they search too hard for it.

A very insightful case study on the failure of Northern Rock shows among others how the bank sustained its high return on equity by increasing leverage, employing a more aggressive funding model and resorting to a higher overall risk profile as credit margin fell and regulators were getting complacent.

A small case study on failure to grasp the basics of value creation

The huge profit growth does not only belong to large Indonesian banks. One small bank, Bank Mutiara (yes, formerly known as Bank Century that was rescued by Indonesia’s Deposit Insurance Corporation - LPS) has recently released dazzling figures, posting a 247.8% profit surge. Its company website reports ROE of over 58% in H1. On the other hand, its capital adequacy ratio fell to 9.3% (very low) from 12.8% (low) a year before while its breach with the central bank’s large exposure rule was reportedly much higher over the same period, indicating higher concentration risks.

The owner, the aforementioned LPS, seeks to sell the bank in August 2011 at more than 8 times book value of equity!

With that last minute credit acceleration, the bank has tried too hard to impress would-be investors. The rapid credit expansion before the target date of divestment is planting the seeds for failure down the track. I believe Bank Mutiara and LPS should come up with a more credible, longer-term divestment strategy instead, since the talking of sale target this year and the hiring of financial advisors are actually quite a waste of time and money. 

The flawed focus on short-term performance measures reminds us of the famous interview with Jack Welch, who is regarded as the father of the “shareholder value”. Mr. Welch said that “…short-term profits should be allied with an increase in the long-term value of a company. On the face of it, shareholder value is the dumbest idea in the world,”. Furthermore, “Shareholder value is a result, not a strategy .. . Your main constituencies are your employees, your customers and your products".

In a nutshell, Bank Mutiara should have no delusion of being capable of creating shareholder value in a short period of time by bolstering income through overextended credit growth.

Concluding remarks

Following the bail-outs in response to the 2008 financial crisis, the public in the U.S and Europe has questioned if the supranormal return on equity was really something bankers should be proud of, if it had been obtained by repressing deposit rates, charging elevated lending rates and service fees, or just exploiting expectations of government support through excessive risk taking and size expansion.

Valuation and profitability of several Indonesian banks are staggering. Based on early warning signals, the regulator should be alert on the sector's drives to sustain the excess profitability by engaging in highly risky entrepreneurial activities on the back of perverse incentive schemes that include excessive bonuses and compensations.

Especially the pursuit of a profit in the short run is not consistent with the stability that especially systemic banks should be about. We know that de facto, large banks will be protected by the government since the damage to the economy caused by their failure would be too great. Even a bank as small as Bank Mutiara might be supported again by public funds in case of another failure.

The banking sector's excess profitability or an appearance thereof can also lead to misallocation of scarce resources.

Think of the latter in terms of high-talented young engineering graduates going into the financial sector as it pays much higher salary than engineering and manufacturing sectors.
The importance of fostering employment in production-oriented sector and new economic activities is substantiated by Dani Rodrik (2011) here.

Closer supervision and adoption of sound regulatory standards might make Indonesia’s banking sector less lucrative eventually, but the country will have the benefit from having fewer bank failures and more sustainable economic growth.

Regulators can't be complacent, especially now

Former Fed chairman Alan Greenspan recommends that "regulators must risk more to spur growth" (FT 26 July 2011). Still calling for loose regulation, Greenspan does not appear to have changed his minds after all....

Weighing growh and financial stability risk trade-off
In emerging economies, financial sector deepening through deregulations is an important growth strategy. Greater financial intermediation is expected to improve economic allocations and enhance central banks’ monetary policy transmission mechanism, among others. 
Nonetheless, financial deepening causes economic growth as long as the relationship is not exploited (Rousseau and Wachtel, 2007). Too rapid credit growth would actually weaken banking system.


In Indonesia, the main cheerleader for the currently above average credit growth is the central bank itself through its loan-to-deposit (LDR) regulation, where banks with LDRs falling outside a targeted range face higher reserve requirements. As noted elsewhere in the blog, such jawboning would easily tempt banks to relax their underwriting standards or saddle (smaller) banks with liquidity constraints.

Having been exposed to several headline economic and banking crises, I support the premise that closer regulation and supervision of banks will do more good than harm. A loose or exceedingly pro-growth financial sector policy tends to inspire perverse behavior. The consequences of greed on judgment of bankers, informational asymmetries and the asymmetry between private gains and socialized losses are among many good reasons for a close regulatory supervision of banking and finance.

Indicative of pervading complacency in Indonesia is the sector's refusal to adopt the Financial Stability Board (FSB) recommendation on sound compensation practices. Both the banking sector and the regulator underplay its relevance arguing that compensation level hinges on market conditions and should be up to shareholders to decide.
That is exactly the misplaced view that had prevailed before the 2008 crisis. While the concerns about the cost of salaries to the banks are for shareholders to sort out, the bonuses tend to reward short term payback and do not sufficiently penalize long run losses. It is squarely the business of the regulator when there are concerns that bankers have incentive schemes that lead to unnecessary risk taking with the public money. It seems for now Indonesia's regulator passes the opportunity to promptly benefit from the global momentum of reform in this area.
To give idea of executives' compensation level and bonus structure in these days, here. FSB is currently finalizing its second peer review on remuneration practices in the G24 group as reported here.

Need for narrowing the regulatory gap
Strong profitability of Indonesia's banks and confidence gained out of the success to escape from the financial crisis might account for the delayed adoption rate of the global regulatory initiatives including Basel II.  This is not unique to Indonesia since delayed implementations are more of the rule than the exception in the case of developing countries. With the introduction of Basel III - with Europe leading the pack based on the recent opening for the CRD IV consultation - the regulatory gap is set to widen even more.
For a survey of the regulatory gap between developed and developing economies, see Young Cho (2010) paper published in the ICFR website. For a summary of CRD IV by Cicero-Group, here.

Different pace of adoptions will create an unlevel playing field but could also form a regulatory arbitrage risk that may destabilize regional or global financial systems. One might argue that emerging economies’ financial sector is relatively small and domestically oriented, mitigating the risk concern. Again, the point is that financial sector is different from other sectors. Due to the ease with which losses can spread through the financial system in increasingly interlocking economies, regulatory developments should be subject to certain standardization and harmonization.

Vigilance called for (especially now)
Contrary to Mr. Greenspan’s emphasis on the primacy of unfettered markets and self-regulation in the financial sector, tight banking regulation and supervision must be sustained instead.

Indonesia's banking sector is presently having a good time, evidenced by high profitability, very easy financing conditions and bullish stock valuation - probably among the highest in the G20 countries! 
Under Basel III, regulators can solicit to operate the countercyclical buffer to discourage credit excesses at this point of economic cycle. Without Basel III, Bank Indonesia (BI) could fall back to other prudential measures on the menu (e.g. lower loan-to-value ratio, higher reserve requirement, remuneration policy).

Above all, BI should be prepared to ‘take away the punch bowl just as the party gets going’ (William McChesney Martin about the art of central banking).

Relevance and insights of Basel III for Asian banks: The case of Indonesia

A version of this post is published in the Risk & Regulation Working Group (THE ASIAN BANKER)

Indonesian banks will be among those in Asia entering phase three of global banking reform more easily due to inherent conservatism since the 1998 Asian crisis, says the central bank (The Jakarta Post)

Thanks to ample capitalization, earning power and liquidity, Indonesia's banking sector and its supervisor have valid reasons to be confident for meeting the Basel III standards relatively easily. At least if the compliance challenge is compared to banks in the Eurozone.

But the risk is that one is becoming complacent on a failure to fully understand how consequential the reform (in its fullness) can be. According to the Basel Committee, Basel III is build from Basel II and its adoption should be seen in light of continued improvement of banking system’s infrastructure and incentives in a.o. governance practices, compensation and the moral hazard associated with systemic financial institutions.

The implications of Basel III will be felt sooner than later as the pressure and expectation by the market, general public and regulators grow in significance much earlier than the implementation phase-in from 2015 onwards. In the Netherlands for instance, the central bank has required banks to prepare a migration plan to Basel III and subject them to periodical reporting for monitoring purposes already in 2011.
See for implementation of Basel III in the Netherlands here; For the Central and Eastern European (CEE) region, see the IFCR site here.

Besides its relevance, there are also elements of Basel III that introduce some useful (if not new) insights for policy makers in Indonesia and maybe elsewhere. I will touch upon some of those elements here for further discussion.

Capital adequacy standards
From a sample of the 2010 annual reports of banks listed in the Jakarta Stock Exchange, it is clear that the Indonesian banks are well capitalized according to the Basel III norms, in terms of size and quality of equity base.

Bear in mind however, Indonesia's banks are still to calculate and report the capital adequacy ratios (CAR) according to the Basel II framework. Just in February 2011, Bank Indonesia issued the final rule about the Basel II’s Standardized Approach for credit risk entering into force on 1 January 2012. This highlights the distance Indonesia's banks and supervisor have to travel to get to Basel III environment.

Furthermore, it is less clear how adequate the capital base would be if all the risks are captured in Pillar 1 calculation and Pillar 2 processes in line with the revised Basel II guidelines. On the back of currently high credit growth, capital adequacy can become an issue, if incentives are not given to banks to retain more earnings in the book, which brings us to the next essential insight from the new capital adequacy framework.

Capital Buffers
Basel III contains proposals for a capital conservation buffer and a countercyclical buffer, that is, the build up of buffers in good times that can be drawn down in periods of stress. Under the capital conservation buffer, when a bank’s capital levels move closer to minimum requirements, the bank will be imposed a constraint on its discretionary distributions such as dividend payments and bonuses.

Compared to recent developments in the US and Europe, Indonesia's dividend and bonus policy issues are presently not on the table. This missing agenda is less likely to manifest under Basel III, particularly when there are excesses in payments of dividends and bonuses in a way reminiscent of the situations before the 2008 global financial crisis.

The second kind of buffer will be imposed when, in the view of national authorities, there is an excess aggregate credit growth (e.g. actual credit/GDO ratio > the trend of credit/GDP ratio).

The countercyclical capital buffer guideline provides a relevant insight for gauging a recent central bank initiative. From 1 March 2011, Indonesian banks will face higher reserve requirements as a penalty, if their loan-to-deposit (LDR) ratio falls outside the range between 78% and 100%. Since the average LDR of the sector and the LDRs of the biggest banks such as Mandiri and BCA are currently below the range, aggregate credit growth in 2011 and beyond can easily come out higher than about 25% recorded last year.

I believe the authority should refrain from using such prudential rule to stimulate credit growth. It is very easy for an individual institution to be tempted into a reckless lending spree given this incentive. While Indonesia’s credit-to-GDP ratio is relatively low, periods of excess aggregate credit growth are found to be associated with the build-up of banking crisis risk. Therefore, Basel III proposes the countercyclical buffer, among others, to deal with an excessive asset growth (i.e. too high credit multiplier).

Stating the insight differently: When operating under the Basel III regime, it will be quite unlikely that Bank Indonesia introduces such regulation that would spur lending and yet at the same time may be required under the Basel III guidelines to impose a countercyclical capital buffer as credit growth is far exceeding nominal GDP growth.

Liquidity standards
The Basel III minimum liquidity standards are comprised of the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The LCR ratio is designed to make banks more resilient to potential short-term disruptions in obtaining funding by requiring banks to have sufficient high-quality liquid assets. The NSFR is designed to address longer-term structural liquidity mismatches. Taken together, this liquidity framework covers asset-liability sides of the balance sheet and provides incentives for banks to use stable sources of funding.

Given the banks' low loan-to-deposit ratio, high holding of IDR government bonds and reliance on deposit funding, Indonesian banks and regulators are understandably not concerned about their ability to deal with the Basel III requirements. But the liquidity framework implications are potentially more significant than it may appear at first glance.

For example, while demandable deposits (e.g. current accounts and savings) are recognized as stable funding source, time deposits with residual maturity of greater than 30 days markedly have higher weight (i.e. higher stable funding value) in the calculation of total stable funding source.

All else equal, banks are compelled to accumulate more time deposits.
Let's look at a sample of the 2010 annual reports of small and big Indonesian banks focusing on their retail funding structure:

a. Most big banks or banks with strong franchise value show low time deposits as % of total retail deposits (average < 15%).
As comparison, the ratios are higher in countries where central banks impose higher reserve requirements on demand deposits and savings deposit (re: Financial statements of Brazilian and Turkish banks). For a general overview on the use of reserve requirements as a policy instrument see Montoro and Moreno (2011);
b. Smaller banks have higher percentage of time deposits, but average remaining maturity is often less than 30 days and will thus be treated less favorably under Basel III;
c. Time deposits rate (in Indonesia) is notably much higher than savings rate.

The fact that cheaper sorts of retail deposits account for the lion share of the total funding explains, in my view, why net interest incomes of the Indonesian banks, especially the bigger ones, are very high compared to other countries.

As a consequence, Basel III implementation will directly and indirectly raises funding costs and compress profitability as banks will need to increase longer term, more expensive, funding sources, or increase the share of low yielding high-quality assets.

The Basel III liquidity framework also introduces several monitoring metrics that supervisors will employ to assess the liquidity risk of a bank, most notably in regard to concentration of funding and the LCR by currency. An LCR by currency for example will likely lead Indonesia’s banks to cover their foreign currency customer deposits by holding low yielding USD-denominated high-quality bonds. Furthermore, concentration of funding by product types, currencies, maturity etc. will be part of monitoring tools and disclosure requirements.

Beyond the Basel III context, see an increasingly popular paper by Shin (2010), which emphasizes vulnerabilities of banks from the reliance on unstable short-term funding and short-term foreign currency liabilities.

Concluding remarks
A number of observers tends to think that the overall regulatory reform led by the Basel Committee is made in response to the financial crisis that has little relevance to Indonesian banks with business mix primarily in basic banking without much complex derivatives activities. See for a critique on effectiveness of Basel III in Asia, Milne (2010).

The Basel III accord, however, encapsulates both macro and micro prudential policy frameworks. It has relevance on capital and liquidity risk management as well on incentives and related regulations in the banking sector. Eventual implementation of Basel III will raise the costs of banking as well as change the Indonesian banking business model and financial market more significantly than initially thought.

While actual implementation dates may seem to be on the distant future, understanding its insights will raise current public awareness of the perils of excessive credit growth and fragility of bank liabilities. Especially when the economy is in the middle of an upturn, Basel III is an opportunity for the regulator to shore up its policy instruments and should be embraced earlier than later.

Preparing for future banking crises

"An overhaul of financial regulation .... will be a failure if we could not contemplate the failure of a firm such as Goldman Sachs" (said Federal Reserve Chairman Ben Bernanke). “That is, there needs to be a system by which Goldman Sachs will go bankrupt and Goldman Sachs’ creditors could lose money" (15 Feb 2011 Bloomberg).

While the intention to design such a system (a.o. living wills, bail-in mechanism) deserves supports, in practice, hurting creditors or permitting a bank to bust outrightly, let alone a big one, will remain a very rare decision. I still believe the current financial crisis was immediately set off by the collapse of Lehman Brothers and that the potential cost of its rescue would have been much less than the cost of the global financial crisis that followed, in terms of economic activity and public finance.


This said, rescuing a bank using public money would always be controversial. In Indonesia, we know the case of Bank Century, which, probably by hindsight, should have been liquidated instead because it was too small to trigger a systemic crisis, especially when the coverage of the deposit insurance was high enough to ease depositors' worry at that time.

Revisiting the lessons to be learned
A banking crisis can arrive anytime anywhere in current environments.  
In the last few days, South Korea's financial regulator has temporarily suspended seven savings banks to avert an overall systemic crisis (WSJ, 22 February 2011). 
Those banks have insufficient liquidity to meet a surge of withdrawals and inadequate solvency due to their exposures to the weak South Korean real estate market. The embattled saving banks have to solve their problems on their own or seek to be acquired by large commercial banks.


In preventing it from developing into a systemic crisis, the Korean regulator has acted early enough and found no need to involve public money. Though in a different stage and extent of savings banks crisis, similar responsiveness and decisiveness have been demonstrated by Spain's government in dealing with beleaguered  savings banks, 'Cajas' (FT) that are excessively exposed to the distressed property sector.

Spain's regulatory regime had received recognition for its prudence before the 2008 crisis (e.g. application of forward looking loan provisioning) - at least until recently - and I think its banking sector has defied additional pressures in the last few months relatively ok.

Of course, the Spanish case is not necessarily an ideal reference for the point that is being made here. For instance, the government may still need to nationalize Cajas if they fail to timely raise fresh capital. Or losses could turn out to be much greater than expected due to the severity of the real estate crisis.

On that note, allow me to underscore the lessons from the past and the recent experiences when contemplating possible banking crises in the future:


1. When bail-out decision is called upon, then it is two to midnight. The correct decision is most likely to approve the bail-out because the economic cost is likely to be lower and very often, the beleaguered banks tend to be deemed 'more systemic' in turmoil than in normal economic condition. Rating agencies (e.g. S&Ps) seem to have understood this rationale by planning to modify its rating methodology in order to give more weights to the state support rating component.
2.  But 'systemic' banks can also be too big to rescue. Irish banks for example turn out to be too-big-to-save for the nation's indebtedness capacity.

It follows from the above that any meaningfully sizeable bank (incl. small-medium size) in any country will likely be considered too big too fail, or too inteconnected to fail. But they can also tend to be too big to save, yes also in Indonesia. For guidance to assess systemic importance of banks, here.

The road ahead to find a system, such as the one desired by the Fed Chairman to avoid a Lehman Brothers redux is daunting. Although a resolution that imposes losses on non-common capital instruments is better than a bail-out that uses public funds, establishing living wills for the largest institutions, for instance, is a complex and multi-faceted undertaking (for a discussion on living will see here). We need more time and study to ensure that the wind down plans will work from the cost-versus-benefit perspective.

That is why, it is of paramount importance that regulatory institutions and policy makers employ robust early warning signals, promote prompt corrective actions,  and minimize sources of moral hazard in the financial system while they still can.... Because one cannot fight moral hazard when the financial sector is in turmoil.


In continuation to the points stressed in the previous posts, moral hazard and adverse selections should be addressed by appropriate institutional designs and policies. For example (no particular order), by an independent supervisory and monetary policy making body,  smaller coverage of deposit insurance & risk based deposit insurance premium setting, high quality of risk disclosures, sound corporate governance and remuneration schemes....


For a range of possible approaches the Fed Chairman might have in mind to offset moral hazard created by systemic banks, see an FSA's paper here

Deposit insurance scheme and hidden risks to fiscal and financial stability

Indonesia has a track record of prudent fiscal management prior to the global financial crisis and only introduced a modest stimulus in 2009 and 2010. With its fiscal position among the strongest in ASEAN (see below) and perhaps among emerging economies, Indonesian fiscal outlook is arguably not a hot topic today.

Source: Budina and Tuladhar (2010)

Yesterday's parliamentary briefing by LPS (Indonesia's Deposit Insurance Corporation), however, reminded us of potential fiscal risks arising from the curent deposit insurance arrangement, which were unfortunately left undiscussed. It appears that merely the case of Bank Century (the fallen bank controversially taken over by LPS in 2008) has fascinated the lawmakers and the media....

I am quite puzzled by, first of all, the still very high level of the current deposit insurance coverage. And it seems that the Ministry of Finance has voiced no plan to cut back the scope of the scheme and to refocus on protecting smaller depositors as intended by the 2004 LPS law (see its enclosed notes).

Assuming USD 1 = IDR 10,000 for convenience sake - today’s rate is about 9000 rupiah per US dollar - the insured amount is USD 200,000 since end-2008. This figure is high in relation to the Indonesian per capita income (now almost USD 5000 per annum) and also, compared to the median size of guaranteed customer deposits in developed countries (i.e. USD 130,000).

LPS and the state are close to offering a blanket coverage of retail deposits, which will eventually damp the risk senses of depositors and diminish incentives for banks to remain prudent.

Secondly, I am afraid LPS’ capital needs to be beefed up as a result of the expanded guarantee (from USD 10,000 to USD 200,000!) and considering that the fair value of its equity stake in the rescued and closed banks is less than the book value.

Note that according to the LPS law (2004), it is the Ministry of Finance that will provide liquidity assistance and/or equity injection should the LPS asset - reportedly about USD 2.25 billion as per end November 2010 - fall below its original equity amount (i.e. USD 400 million). With total insured deposits amounting to approximately USD 130 billion (about 76% of GDP), use of tax money would inevitably be solicited IF one or two small-mid sized banks collapses.

Moral hazard

The first issue concerning the large insurance coverage per customer gives rise to moral hazard. Moral hazard here arises when bankers run high risks, notably liquidity risks, and reap profits as they think the government will help if things go wrong.

The current financial crisis has taught us how the moral hazard problem is seriously damaging. The implicit guarantee and, very often, the underpriced funding (through its access to central bank borrowing facilities in combination with easy monetary policy) enabled banks in industrial countries to pursue above-average profitability targets and create conditions for excessive remunerations. See among other this BIS/Bank of England article surrounding the implications of the banking safety net.

The close relationship between the generous deposit insurance and banking sector profitability might also apply in Indonesia. A rigorous analysis on the topic is yet to be made but this news article says that Indonesian banks would book staggering profits for 2010.

Possible underfunding

Indonesia is recognized by the IMF as one of the pioneers in fiscal risk analysis among emerging market economies.

Nonetheless, banking crises (see the IMF new database) caused some of the largest fiscal costs arising from contingent liabilities and therefore should take a more central stage in the Ministry of Finance' fiscal risk statements. Implicit or explicit guarantees usually do not cost much. But when the guarantees are called upon, what they cost often come out as an ugly suprise.

Recall again the current Irish saga. Ireland is an exemplary story of rapid growth with high scores on competitiveness and macroeconomic policies, but now being overwhelmed by sovereign default threats since the government was (or felt) obliged to nationalize the banking sector, whose size was much larger than Ireland's economy.

If LPS is indeed underfunded, it is only fair and logical that the banking sector raises its contribution to LPS. It will not only trim down the fiscal risk but also the hidden risks to financial stability inherent in a banking sector that enjoys an implicit state guarantee, and low interest rates environment thanks to LPS' implicit customer deposit rate ceiling and central bank's stimulative monetary stance (see my previous post).

Furthermore, I believe that in order to moderate the identified moral hazard problem, LPS' insurance premium soon has to be set on risk-sensitive bases where lower rated banks pay more and banks perceived to be safer pay less.

On BI independence and Indonesia's natural rate of GDP growth

On 5 January 2010, Bank Indonesia decided to keep its main interest rate reference (the BI rate) at 6.5% because inflationary threats are deemed to come from supply fronts as reflected by surges of (volatile) commodity and food prices. BI believes and hopes (see the last paragraph of its published statement) that the government will address the supply side issues (e.g. production capacity and distribution system) to combat rising prices.

This line of reasoning needs to be checked once and again since BI might be overrating supply side issues and the importance to further enhance policy coordination with government in addressing them. I believe, in the long run, inflationary effects of supply shocks depend on propagation through expectations and inflationary inertia. If implemention of its inflation targeting is credible, this propagation can be limited. Getting involved too far in addressing supply side issues could weaken BI's focus and accountability.

BI should also retain its independence. In my view, holding up the economy via easy monetary policy now is not opportune and could discourage productive investment in sectors where productivity gains are high (industry, education, innovation) in favor of activities linked to credit (real estate, finance).

BI should employ instruments to tackle inflationary pressures at an early stage and guide inflation expectations. It also needs to look at its macroprudential tools chest to prevent (future) asset bubbles, which are currently indicated by surging real estate and stock prices. Raising rates rapidly later to contain inflation in a "leaning against the wind" mode can be detrimental to output and financial stability. To prevent expectations of higher inflation and bigger problems in the future, BI should send strong signal to investors. See for those interested, a review discussion on the timing of monetary policy measures here. Or a cautious view of monetary policy possibilities to prick bubbles here

The fact that the GDP growth rate is 'only 6%' in 2010 does not mean BI has a room to further boost economic growth by essentially over-encouraging banks to expand credits.

Though Indonesia's credit-to-GDP ratio is lower than neighbouring countries, it is the rise of the ratio above the trend (read: too high loan growth) that precipitates the most serious episodes of banking sector problems in the world. That is why the Basel Committee recommends using the trend in credit-to-GDP ratio as a major determinant of required countercyclical capital buffer in the future (under the Basel 3 Accord).

Given its institutional constraints, underdeveloped infrastructure and other supply related challenges, 6% maybe the natural rate of GDP growth for Indonesia at the present moment. Stimulating demand to achieve growth above that rate would only be inflationary and lead to external imbalances.

The central bank of Indonesia needs to focus on its principal objectives to maintain price stability and the stability of the banking sector. Trying too hard to alleviate long-term constraints with purportedly 'pro-growth' policies means planting the seeds of future financial crashes.

By pursuing a more credible inflation targeting, BI will give incentives to the government to focus more on its investment in infrastructure and institutional capabilities, shore up the fight against corruptions and facilitate technological innovations. For in the long run, all of that are positive for productivity growth (hence the supply side!) and will likely be associated with lower inflation (see e.g Mt. Kiley, 2003)